Tax When You Remortgage
By Carl Bayley BSc ACA
"What, no tax at all, that's amazing! Well, thanks a lot, that's wonderful news."
This is the kind of reaction I often get when people ask me about the tax consequences of re-mortgaging their properties.
The situation is a pretty common one. You have a property which you bought some years ago, and which has risen significantly in value since then. Rather than sell the property, you can realise the 'profit' from this growth in value by re-mortgaging and thus obtain the cash value of your equity by different means.
However, whilst this might initially seem to be a very good way of avoiding tax on the growth in the capital value of your investment properties, there are some long term dangers inherent in this strategy which could ultimately prove to be your downfall if you are not prepared for them.
The contrast between the initial tax-saving benefits of re-mortgaging and the potential ultimate pitfalls of the strategy is what leads me to call this scenario 'The Tender Trap'. It's tender because of its initial apparent benefits, but it can prove to be a costly trap from which it is difficult to escape.
More about the trap later, though. To begin with, let's look at the short term benefits of the re-mortgaging strategy.
In the short term, this method works extremely well from a tax point of view. Potentially, in fact, realising equity value through re-mortgaging can produce benefits under each of the three main taxes which affect property investors - Capital Gains Tax, Income Tax and Inheritance Tax. To illustrate these benefits, let's look at an example.
Example Part 1
Steve has a buy-to-let property in Essex which has grown significantly in value since he bought it for £25,000 in November 1998. In fact, the property's current market value is £85,000.
However, Steve feels that property values in Essex are unlikely to show any further significant increase in the foreseeable future and he now wishes to invest in some new developments in Leeds.
In order to pursue his new investment opportunity in Leeds, Steve will need to 'cash in' his equity in his Essex property. Initially he considers selling the Essex property, but he is horrified to learn that he would have a Capital Gains Tax bill of £20,400. (He has already utilised his annual exemption elsewhere.) After repaying his original mortgage of £20,000, Steve would be left with only £44,600 to invest in Leeds.
Instead of selling the Essex property, therefore, Steve decides to re-mortgage it. His new mortgage is at 85% of current value, £72,250. Hence, after repaying his original mortgage, Steve has freed up £52,250 of equity value in cash. He therefore has an additional £7,650 (or 17.2%) more cash available for his new investment than he would have done if he had sold the Essex property. And, what's more, he still has the rental income from his original property.
Benefit 1: Capital Gains Tax
Capital Gains Tax can generally only be charged where there is a disposal of an asset. If you sell a property, you have made a disposal and hence, usually, there will be Capital Gains Tax to pay.
On the other hand, however, when you re-mortgage a property, you have not actually made any disposal, as you still own the property. Hence, although you will have realised some of your capital, you cannot be charged any Capital Gains Tax.
Although, in our example, Steve did this for investment purposes, this Capital Gains Tax benefit remains equally true whatever your reason for re-mortgaging a property.
Example, Part 2
Steve uses the £52,250 which he generated by re-mortgaging his Essex property as a deposit on a buy-to-let development in Leeds.
However, when he is completing his next Tax Return, Steve is uncertain what to do about the mortgage interest he is now paying on the Essex property. Fortunately, his friend Matthew (a Chartered Accountant) is able to point him in the right direction.
Matthew explains that the portion of the interest which relates to the original £20,000 loan (i.e. 20,000/72,250ths or 27.7%) should continue to be claimed against the rental income from the Essex property and the remainder (52,250/72,250ths or 72.3%) can be claimed against rental income from the Leeds properties.
"In fact", Matthew explains, "you could even have claimed the interest on the new part of the borrowings if you had re-mortgaged your own home instead because it's where you spend the money that matters, not where it came from."
Benefit 2: Income Tax
Where the funds generated by re-mortgaging an existing property are used to purchase new investment properties, the interest on the new borrowings can be claimed against the income from the new properties. This remains true even if the re-mortgaged property itself is the borrower's own home. The interest relief remains available as long as the funds are invested for business purposes.
Sometimes, however, the borrower will re-mortgage a property for other reasons - perhaps simply to provide living expenses. Whilst this will still produce the Capital Gains Tax benefit described above, there will be no Income Tax relief for the interest on the new borrowings in this instance.
Example, Part 3
For the next ten years, Steve continues to re-mortgage his existing properties and invest his realised capital growth in new buy-to-let developments. By September 2014, he has 12 properties in Essex, Leeds and Newcastle worth a total of £2,500,000. His borrowings at this stage amount to £1,400,000 in total, giving him a total net equity value in his property portfolio of £1,100,000.
Steve happens to bump into his old friend Matthew, who he hasn't seen in years, and tells him how well his property portfolio has grown. "That's great", says Matthew, "have you done anything about the Inheritance Tax though?"
Once again, Steve is horrified to discover that he has a huge potential tax bill on his properties - this time Inheritance Tax of £440,000. "Well, I'm wealthy enough now", he thinks, "I'll stop investing in new properties, live off the existing ones and give as much as I can away to my family."
For the next ten years, Steve continues to re-mortgage his properties up to 85% of their market value and he spends or gives away the proceeds. By 2024, his portfolio is worth £5,000,000, but he has total borrowings of £4,250,000, leaving him with a net equity value in his portfolio of only £750,000 and thus reducing his potential Inheritance Tax bill to only £300,000.
Benefit 3: Inheritance Tax
Re-mortgaging your properties as much as possible is an effective way to limit the net value of your estate for Inheritance Tax purposes. Rather than selling properties, which creates Capital Gains Tax liabilities, this enables you to give away some of the value of your assets, hopefully tax free (as long as you survive for seven years after making the gift).
Of course, to save Inheritance Tax, you will need to spend or give away the proceeds of re-mortgaging your properties, so this technique does not allow you to claim any Income Tax relief on the new borrowings.
Following this method may also put a severe strain on your cashflow. One of the ways to alleviate this would be to use some of the funds realised through re-mortgaging to purchase annuities, thus keeping the value of your estate down for Inheritance Tax purposes, whilst still providing you with an income during your lifetime.
Naturally, you need to be able to afford to spend or give this money away and still be able to pay the interest on your ever-increasing borrowings, so this strategy is not for everyone!
So far, we've looked at the 'tender' part of the re-mortgaging strategy, namely the potential tax benefits. Now we turn to the trap.
The problem in essence is that Capital Gains Tax is based on the difference between sales proceeds and purchase cost. Hence, in order to calculate the capital gain arising when you sell a property, you deduct the original cost of the property from your sale proceeds.
What you do not deduct in your capital gains calculation is the outstanding amount of the mortgage over the property.
Naturally, if you have used additional borrowings to make improvements to the property, then these costs may also be deducted from sale proceeds.
However, where your additional borrowings have been spent, given away or used to invest in other properties, you will have a liability to the lender without a corresponding deduction in your capital gains calculation. This is what creates the trap and we will go back to our friend Steve to see it in action.
Example, Part 4
In 2025, Steve runs into some financial difficulty and decides that he needs to sell one of his properties. The rental yield of his original Essex property has been pretty poor lately, so he sells this property for £360,000. His borrowings against this property now amount to £306,000, so he realises net proceeds of only £54,000 (even before any sale expenses).
However, as Steve's original cost for the property was only £25,000, he realises a capital gain of £335,000. As he's held the property for over ten years, he is entitled to taper relief of 40%, reducing his gain to £201,000. Nevertheless, as a higher rate taxpayer, he is still left with a Capital Gains Tax bill of £80,400. (Once again, he has used up his annual exemption elsewhere.)
After tax, Steve's sale of the Essex property has actually generated an overall net cost of £26,400!
In fact, if Steve were to sell his entire £5,000,000 portfolio, he would need to find an extra £104,000 to pay his tax bill!
Escaping The Trap
Steve's story is a lesson to us all. It's only an example, I know, but I have met property investors who are in a very similar position, or who will be if they keep on the way they're going.
Escaping the trap is possible, but does require some drastic action. The first option is to hang on to the properties until you die. This resolves the Capital Gains Tax problem and, as we have seen, the level of borrowings keeps the Inheritance Tax bill down.
If Steve had died before selling his properties, the portfolio would have yielded a net sum of £450,000 for his family after Inheritance Tax, rather than creating an overall cost of £104,000. This is because Capital Gains Tax is not charged on death. Furthermore, for future Capital Gains Tax purposes, the deceased's beneficiaries are treated as having acquired the properties at their market value at the time of death.
This is all very well, but what if you can't afford to keep the properties. This could happen for a variety of reasons, rental yields could fall, interest rates could rise. Additionally, as you get older, you may need to employ more help to maintain the portfolio and this will impact on your overall cashflow.
On the other hand, though, if you have insufficient other wealth beyond your property portfolio, you may be unable to fund the Capital Gains Tax bill arising if you do sell!
You could end up not being able to afford to keep the properties, nor able to afford to sell them!
In a case like Steve's, I would probably recommend emigration as his best chance to escape the tender trap. If he went abroad before selling the properties and then stayed away for at least five whole tax years, he would be exempt from UK Capital Gains Tax. Still quite drastic, but not as bad as the previous option.
'Safe Haven' Borrowings
Better still though, it is advisable to avoid getting into Steve's type of situation in the first place. To do this, the re-mortgaging strategy should be limited to a 'safe haven' level.
For properties held for less than three years, the 'safe haven' for your borrowing is 'original cost plus 60% of any increase in value'. On each anniversary of the property's purchase from the third anniversary to the tenth anniversary, the percentage of 'increase in value' which may safely be borrowed goes up by two percentage points. Eventually, for properties held for ten years or more, the 'safe haven' becomes 'original cost plus 76% of any increase in value'.
Keeping mortgage levels down to these 'safe haven' levels should ensure that you will have sufficient net funds arising on a sale of the property to be able to pay your Capital Gains Tax bill. To err on the side of caution, though, I would also advocate reducing the resultant 'safe haven' figure by a further 5% to safeguard against a downturn in property values or any other nasty surprises.
Using a re-mortgaging strategy to build your property portfolio has tremendous potential Capital Gains Tax and Income Tax benefits. Realising your equity through additional borrowings is more tax efficient than selling properties when you intend to reinvest the proceeds in your portfolio.
Re-mortgaging can also be used as a method to keep the value of your net estate for Inheritance Tax purposes down to a reasonable level.
However, a trap awaits the unwary and can, in the most extreme cases, put the taxpayer in a quite untenable position. Sticking to 'safe haven' levels of borrowing should ensure that you don't fall into this trap.